FXI, the Chinese equity ETF, has been in a downtrend and breached an important short-term technical support level.

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What's going on? Is this time to start shorting China and China-related plays?

Extend and pretend, or...

I have seen some traders enthusiastically jump into the bear camp based on these data points, but I would caution about getting overly bearish too early on China. As I wrote before, you have to watch out for the policy response to news of weakness (see Will Beijing blink yet one more time?):

Beijing has exhibited a pattern of pushing a reform agenda, but unwilling to bite the bullet when critical sectors of the economy get pushed to the edge. If history is any guide, the Chinese leadership will continue talking tough on reform, only to see its initiatives get watered down as they run up against entrenched interests.

Consider what was said (and what was not said) in a recent speech by Premier Li Keqiang (via Reuters):

Li, speaking at a news conference on the final day of China's yearly parliament, hinted Beijing would tolerate slower economic expansion this year while it pushes through reforms aimed at providing longer-term and more sustainable growth.

Beijing has a reform agenda, but stability is also important [emphasis added]:

"We are reluctant to see defaults of financial products, but some cases are hard to avoid," Li said. "We must enhance oversight and solve problems in a timely way to ensure no systemic and regional risks."

You have to read between the lines and understand what was not said. They don't like to see defaults of trust and wealth management products, but Li did not say outright that they would allow all shadow banking products go bust, let market forces assert themselves and eliminate the moral hazard problem. Instead, Li said in so many words that they will take steps to "ensure no systemic and regional risks". In other words, count on more bailouts and stimulus.

Based on Li Keqiang's recent statement, it appears more than likely that the Chinese leadership will blink one more time to play the "extend and pretend" game. Expect them to once more stimulate and rescue the economy should growth slow or financial stresses threaten stability.

Already, a number of analysts are already expecting stimulus measures in light of the recent bout of economic weakness (via Bloomberg) [emphasis added]:

Hong Kong stocks fell and copper extended declines following the data, which came two hours after Premier Li Keqiang indicated he was confident the nation would meet what he said was a flexible growth target of "about" 7.5%. The slowdown may test the Communist Party's commitment to give market forces a bigger role in the world's second-largest economy while confronting overcapacity, debt and pollution.

"This is a very fast deceleration," said Yao Wei, China economist at Societe Generale SA in Hong Kong, ranked as the most accurate forecaster of China's gross domestic product by Bloomberg. "This is really beyond the tolerance of the Chinese government. As a result, I think they will cut the required reserve ratio quite soon or do some easing."

Such a reduction could happen "within a few days" if the government wants to achieve 7.5% expansion, Yao said.

What kind of bear?I think that China bears should take a deep breath. I agree with Hale Stewart when he rhetorically asked the question, "Should we be worried about the latest Chinese data?". He wrote:

So -- what do we make of this weakness? Part of it is probably due to the seasonal impact of Chinese New Year's celebration. For the last three years, early year Chinese data has had similar misses but later rebounded. At the same time, many people have noted that as China tries to rebalance its economy, these type of misses may become more pronounced and numerous. But also note China is still growing at a sharp clip. And even if we see the number dip to the 6% range that's hardly a reason to throw in the towel. While it would be disappointing, it would also be a signal the Chinese economy is beginning to mature and achieve first world status.

I have seen some China bears embrace the idea of short positions in Australian miners and base metals in light of recent copper weakness, but the forecast of an extended decline in mining stocks may be a mirage. If copper is so weak, why is the relative performance of mining stocks against the SPX still range-bound?

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Another key indicator of China weakness to watch is the AUDCAD exchange rate. Both Australia and Canada are resource producing economies, but Australia is more China sensitive and Canada is more US-sensitive. China bears should ask themselves why the AUDCAD exchange rate is in an uptrend in light of the recent weakness in Chinese economic data.

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For China bears, a word of advice: "Just be sure that the grizzly bear that you are chasing doesn't turn out to be a koala bear."

Disclosure: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui's blog to ensure it is connected with Mr. Hui's obligation to deal fairly, honestly and in good faith with the blog's readers."

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